markets by governments such as the US, the UK, France and Germany. They are fully
backed by the governments concerned and used as short-term funding instruments, in
part to help smooth out the flow of cash from tax receipts but also, as we have seen, as
instruments to control the supply of money in the banking system and hence the
economy at large. The US Treasury regularly sells bills at auction (minimum
denomination $1000) with maturities ranging from 4 to 52 weeks. The auction cycle
is currently as follows.
* One Month Paper , 4-week bills are offered each week. Except for holidays or special
circumstances the offering is announced on Monday and the bills are auctioned on
the following Tuesday and issued on the Thursday following the auction.
* Three - Six Month, 13-week and 26-week bills are offered each week.
Except for holidays or special circumstances the offering is announced on Thursday
and the bills are auctioned on the following Monday and issued on the Thursday
following the auction.
The participants in the auction are major investment banks and security houses, other
banks and institutional investors, and private investors. There are two types of bid that
can be submitted. In a non-competitive bid the investor agrees to accept the rate
determined by the auction. Most retail investors make non-competitive bids which can
be submitted by telephone or nowadays via the internet. In a competitive bid the
investor submits a rate to three decimal places in multiples of 0.005% (for example,
5.01%) and if the bid falls within the range accepted the investor will receive securities.
In the current system all successful bidders are awarded securities at the same rate,
although a number of alternative systems have been tried over the years. Between
auction and settlement the primary dealers make a market in when issued bills— this
allows traders to take a position in bills for future delivery and settlement.
Discounting Treasury Bills
US Treasury bills, also known as ‘T-bills’, do not pay interest as such. Instead they are
issued and trade at a discount to their face or par value. The discount method, also used
with UK T-bills, goes back to the early days of commercial banking and is sometimes
known as the bank discount method, to differentiate it from modern discounted cash
flow calculations. Financial instruments traded using the bank discount method are
quoted in terms of a percentage discount from their face value rather than at their yield
or rate of return.
Simple Example : Discounting Treasury Bills
An exporter agrees an export transaction with an importer and submits a bill for
£1 million for the goods, payable in one year. The exporter needs to raise cash
today and approaches a bank. The bank agrees to discount the bill at a rate of
10% and pays the exporter upfront £1 million less 10% of £1 million, which is
£900,000. In one year the bank will collect the £1 million payment due from the
importer for the goods.
In the above example the 10% discount from the £1 million par or face value of the
bill charged by the bank is not in fact the yield or return it earns by discounting the bill.
The bank pays out £900,000 today and will receive £1 million in one year. Its return on
the original investment is:
£1,000,000 £900,000 x 100 = 11.11%
£900,000
Clearly the bank must be earning more than 10% on the deal. If it invested £900,000 at10%
for one year it would only have £990,000 at the end of the period. This is very
satisfactory for the bank but not so pleasant for the exporter in the story. The exporter
is effectively paying an interest rate of 11.11% to obtain money today rather than in one
year, as opposed to what looks at first glance like a 10% charge.
Read More : Treasury Bills
